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The Personal Savings Allowance explained

NB: The rates of return quoted are accurate on the date of this blog post’s publication.

A revolutionary change has just been introduced that will help peer-to-peer lenders reduce the amount of tax they pay. At the start of the new tax year on 6 April, the Personal Savings Allowance (PSA) came into effect: this means that most of us can now earn up to £1,000 interest every financial year without being charged any income tax.

More details are in the government Personal Savings Allowance factsheet.

How the system used to work

Until this week, any income received from savings returns or interest on P2P loans was subject to income tax. If your annual earnings, including interest, were less than the annual personal allowance – which was £10,600 in 2015-16 and has now risen to £11,000 – you wouldn’t have to pay any income tax.

But income above this level is taxed at a basic rate of 20%, rising to 40% and then 45% for higher earners. In practice, most people’s savings and loan interest were taxed at 20% and, as a default, banks and other financial platforms deducted tax at this rate automatically. Higher- and top-rate taxpayers then had to pay any extra tax through the self-assessment system.

What impact the PSA will have

The PSA should make the whole system a lot simpler. It means that, for basic-rate taxpayers, they can earn £1,000 in interest with no tax to pay. Higher-rate taxpayers only have a tax-free allowance of £500, while those in the top 45% band get no allowance at all.

This should mean that for most people, all the interest they earn in a given year will now be tax-free. As such, banks and other finance companies will no longer automatically deduct tax at 20%.

The government says that these businesses will pass on information about their customers to HM Revenue & Customs: people whose earned interest is above their PSA will then have the tax they owe collected by having their tax codes changed.

Will I have to pay any tax on the interest I receive?

The PSA applies to the amount of interest you earn: this will depend on how much capital you have saved or lent, as well as the rate of return you get.

When it comes to cash savings, rates are so low at the moment that you would need a large amount on deposit before your PSA ran out. With best-buy instant-access accounts paying around 1.3% a year, you would need savings of more than £75,000 to breach the £1,000 limit for basic-rate taxpayers.

And finally…

One extra piece of good news: you don’t need to do anything to qualify for the PSA as it is applied automatically.

Find out more about tax-free lending at Zopa.